Market effects from the Bean report are meaningful, says LGIM
The recent report* from Professor Sir Charlie Bean confirmed that the UK has been under-reporting growth and over-estimating inflation for some time. This is largely because of a shift towards a services rather than goods based economy.
In today’s Fundamentals briefing, LGIM strategist Chris Jeffery focused on the market implications of this mismeasurement.
“Growth has been better than reported while inflation has been lower. This has implications for investors. If we look at government bond markets, some believe that these are grossly overvalued. But if inflation is lower, then the real yield on these assets is higher – in other words, some of that overvaluation simply disappears” said Chris.
The flip side of lower inflation is higher real commodity prices. Investors sometimes look at commodity prices on a long-term inflation-adjusted basis. Lower inflation levels would therefore mean that current commodity prices look more expensive relative to their history.
“If we assume that inflation has been overestimated by 0.5% for a decade, then real commodity prices are approximately 5% higher than they seem.”
The effects on equity markets are mixed. On the positive side, faster growth means better productivity, which may convince investors of the sustainability and health of the recovery, helping to prolong the equity bull market. However, the fact that inflation is lower than expected could lead to increased volatility.
“With reported inflation already low, adjusting it lower moves us closer to a deflationary world, with existing debts harder to service and roll over, potentially leading to higher defaults.”
*Independent review of UK economic statistics, March 2016
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